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The weakness to start the year in China has its roots in the controversial government intervention last summer to rescue stocks from a rout, which wiped over $4 trillion off share values and sent shock waves around global markets. The ‘rescue’ appeared to have paid off at first as a subsequent market rebound took hold. But it left a worrying overhang both from resulting heavy state ownership and the imposition of a six-month ban on major shareholders (over 5%) from selling positions. With that six-month moratorium now over, investors have seen a new round of ‘pent-up selling’. Some $500 billion of foreign reserves were used up last year to support the yuan and buy stocks. In the end, all it bought them was a little more time to deal with the real issue. The bigger problem in China is that the leverage built up since the financial crisis to support their economy is massive, rising from under 140% of gross output in 2009 to over 220% today, with much of that debt expansion coming from the unregulated ‘shadow banking’ system. The risk to those loans has not yet shown up in any write-downs, losses or means of recovery. Moreover, the economic impact of that spending has become less productive, meaning that are getting much less ‘bank for the buck’.
In the end this is probably the reason why the authorities have tried so hard to prop up financial markets and control currency outflows. They need asset prices to hold up so they can re-liquefy the financial system. These situations rarely end well and we continue to avoid investing in the region. However, given the potential for the government to push even harder on monetary stimulus (i.e. lower interest rates and bank reserve requirements even further) we think it is also too risky to take a short position in Chinese financial markets. Best idea, in our view, is to watch this one from the ‘sidelines.’
With the surprise announcement from the Bank of Japan on Jan 29th that they are moving to a ‘negative interest rate policy’, many investors are seeing this strategy in detail for the first time and are wondering what the rationale is. When a banking system moves to negative interest rates it means that depositors are actually charged to keep their money in an account. The goal of the policy is to discourage investors from leaving funds on deposit at the banks and take the money out and spend it instead. It’s just another attempt to reinvigorate an economy with other options exhausted. The problem so far is that this policy has only encouraged investors to switch their savings to instruments such as stocks, bonds, other financial assets and real estate, driving up those values rather than into any direct spending which would benefit global economic growth. Either way, it’s an unorthodox choice that has distorted financial markets and triggered warnings that the strategy could backfire. If negative interest rates work, however, they may mark the start of a new era for the world’s central banks.
Canadian stocks ‘weathered the storm’ in January much better than most global markets for a change. The collapse in commodity prices since 2011 and the acceleration in this decline in the past year have lead to an outflow of funds from our market in the resource sector. Worries about energy loans and the Canadian housing market have also lead to pressure on bank stock valuations. The net result is that Canadian stocks versus their book values have become almost as inexpensive as they were at the market lows in 2009. While critics now dismiss the importance of price-to-book value as a valid indicator, since it is an indicator of historical cost rather than profitability, it has been a better indicator over time for the financial industry in particular. The book values of many resource companies would still include the inflated values of many of their acquisitions over the past decade but, outside of that, it does seem to indicate that we are closer to the bottom than the top in terms of Canada’s stock market.
